Thursday, 17 December 2015

Absolute Bankers Index

Huge bankers

Blogs aplenty get posted on the internet about the Australian banking system being swept away by a property market correction, resulting in insolvency or negative equity for the lenders, with massive bail-outs and the major banks being nationalised.

Trouble is, commentary can be so cloaked in emotive language that it can be hard to know what is real and what is not.

While eating a curry last night (jalfrezi, pretty tasty), I got thinking as to whether I could fashion a monthly index that would need no commentary, since it will just tell us which of Australia's key financials are genuinely at risk of insolvency and when.

13 key financials

Below, therefore, I have selected a baker's dozen of the key market players and henceforth will track the respective market capitalisation of each in the middle of each of calendar month through 2016 and beyond.

The index will comprise the four major banks, being Commonwealth Bank (CBA), Westpac (WBC), ANZ (ANZ) and the National Australia Bank (NAB), and a number of other significant ASX listed lenders.

I've also included three key players from the real estate space: developers Lend Lease (LLC), Mirvac (MGR), and the Dexus Property Group (DXS), which is more aligned with commercial, retail and industrial property interests.

And while it is a comparatively small beast with a market capitalisation of less than $1.5 billion, there is furthermore a place for everyone's favourite shorting vehicle Genworth Mortgage Insurance (GMA), since it represents such a neat proxy for residential housing market risk.

The constituents will thus include the following 13 companies, which collectively comprise about a third of the total value of the Australian Securities Exchange (ASX).

While markets do not always value securities rationally, over any meaningful time horizon the invisible hand should price in risk appropriately, in order that we can appraise with clarity whether any of these key financials really are heading down the gurgler.

Behold, the Absolute Bankers Index ("ABI")!

Risk weights stepped up

At around the time of the market peak for financials earlier in 2015 the big four banks were valued at a thumping $475 billion.

However, since undertaking capital raisings in response to higher mortgage risk-weights the prospect of lower shareholder returns has seen the combined valuation of the "big four" pull back sharply to $390 billion today.

Before the financial crisis in the middle of 2007 the big four banks were collectively valued at around $250 billion, so the market hasn't gotten all that aroused about the prospect a cataclysmic event just yet, it must be said, although low interest rates have unquestionably contributed to a lust for yield.

It is hardly a foolproof index, of course, and the gyrations of the market will naturally impact earnings multiples from day to day, inevitably resulting in no little "noise".

And as we have already seen, more stringent capital requirements - which ultimately are designed to make the banks safer - can paradoxically result in lower valuations as returns on equity (RoE) are trimmed back. Such is the nature of the risk-return trade off.

Nevertheless, logically if a major lender or one of these other key financials really is going to go bust, then valuations must by definition fall heavily from here, and the index must in turn also be crunched hard from where it is today at $482 billion.